EC311: International Economics

Trade Theories |||

Dr. Hussein Hassan

Email: Hussein.Hassan@reading.ac.uk
Office Hours: Wednesday 10-12pm and Friday 10-11am
Room: EM289

Spring 2020/21

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David Ricardo: Comparative Advantage

Recall that:

According to Ricardo’s law of comparative advantage even if a nation

has an absolute disadvantage in the production of both commodities,
there is still a basis for mutually beneficial trade. Consider again the
following table:

US UK
Wheat (Bushels/Labour-Hour) 6 1
Cloth (Yards/Labour-Hour) 4 2

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David Ricardo: Comparative Advantage

According to Ricardo, the value of a commodity depends exclusively on

the amount of labour going into the production of this commodity. This
implies that:

1. Labour is the only factor of production.

2. Labour is used in the same fixed proportion in the production of

all commodities.

3. Labour is homogeneous.

Since not all of these assumptions are true, we cannot base the
explanation of comparative advantage on the labour theory of value.

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The Opportunity Cost Theory

In 1936, Haberler explained the law of comparative advantage using

the opportunity cost theory. According to the opportunity cost theory:

 The cost of a commodity is the amount of a second commodity that

must be given up to release just enough resources to produce one
additional unit of the first commodity.

 No assumption is made here that labour is the only

factor of
production or that labour is homogeneous.

 Consequently, the nation with the lower opportunity cost in the

production of a commodity has a comparative advantage in that
commodity (and a comparative disadvantage in the second
commodity). 4
The Opportunity Cost Theory

For Example:

 if in the absence of trade the US must give up two-thirds of a unit of

cloth to release just enough resources to produce one additional unit
of wheat domestically, then the opportunity cost of wheat is two-
thirds of a unit of cloth (i.e., 1W = 2/3C in the US).

 If 1W = 2C in the UK, then the opportunity cost of wheat is lower in

the US than in the UK, and the US would have a comparative
advantage over the UK in wheat.

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The Opportunity Cost Theory

 In a two-nation, two-commodity world, the UK have a comparative

advantage in cloth (i.e. 1C = 1/2W in the UK compared with 1C =
3/2W in the US).

According to the law of comparative advantage, the US should

specialise in producing wheat and export some of it in exchange for
British cloth. This is exactly what we concluded earlier with the law of
comparative advantage based on the labour theory of value, but now our
explanation is based on the opportunity cost theory.

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The Production Possibility Frontier (PPF)

The Opportunity Cost theory can be illustrated with the Production

Possibility Frontier (PPF). The PPF is a curve shows the different
combinations of the output (two commodities here) that a nation can
produce by fully utilising all of its resources (or inputs).

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The Production Possibility Frontier (PPF)

From this table, it is clear that:

 The US can produce 180W and 0C, 150W and 20C down to 0W and
120C. For each 30W that the US gives up, just enough resources are
released to produce an additional 20C. That is, 30W = 20C. Thus, the
opportunity cost of one unit of wheat in the US is 1W = 2/3C and
remains constant.

 On the other hand, the UK can produce 60W and 0C, 50W and 20C
down to 0W and 120C. It can increase its output by 20C for each 10W
it gives up. Thus, the opportunity cost of wheat in the UK is 1W = 2C
and remains constant.

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The Production Possibility Frontier (PPF)

Both of the US and UK production possibility schedules given in the

previous table are graphed as production possibility frontiers in the
following figure. Each point on a frontier represents one combination of
wheat and cloth that the nation can produce.

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The Production Possibility Frontier (PPF)

From this figure, it is clear that:

 Points below the PPF are also possible but are inefficient, in the
sense that the nation is not using all of its resources or the best
technology available.

 On the other hand, points above the PPF cannot be achieved with the
current level of resources or technology available to the nation.

 The downward slope of the PPF indicates that if the US and the UK
want to produce more wheat, they must give up some of their cloth
production.

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The Production Possibility Frontier (PPF)

From this figure, it is clear that:

 The fact that the PPF of both nations are straight lines reflects the
fact that their opportunity costs are constant.

 The slope of the PPF gives this opportunity cost and is sometimes
referred to as the marginal rate of transformation.

 From the previous figure, the slope of the US PPF is 120/180 = 2/3 =
opportunity cost of wheat in the US. The slope of the UK PPF is
120/60 = 2 = opportunity cost of wheat in the UK.

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The Production Possibility Frontier (PPF)

From this figure, it is clear that:

 On the assumptions that prices equal costs of production and that

the nation does produce both wheat and cloth, the opportunity cost of
wheat is equal to the price of wheat relative to the price of cloth (𝑃𝑊
/𝑃𝐶 ).

 Thus, in the US, 𝑃𝑊/𝑃𝐶= 2/3 and inversely 𝑃𝐶 /𝑃𝑊 = 3/2 = 1.5. In the

UK, 𝑃𝑊/𝑃𝐶= 2, and 𝑃𝐶 /𝑃𝑊= 1/2. The lower 𝑃𝑊/𝑃𝐶in the US is a reflection
of its comparative advantage in wheat. Similarly, the lower
𝑃𝐶 /𝑃𝑊in the UK reflects its comparative advantage in cloth.

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Gains from Trade

With trade, the US would specialise in the production of wheat (the

commodity of its comparative advantage) and produce at point B
(180W and 0C) on its production possibility frontier. Similarly, the UK
would specialise in the production of cloth and produce at B (0W and
120C).

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Gains from Trade

 If the US then exchanges 70W for 70C with the UK, it ends up
consuming at point E (110W and 70C), and the UK ends up consuming
at E (70W and 50C).

 Thus, the US gains 20W and 10C from trade (compare point E with
point A), and the UK gains 30W and 10C (compare point A with point
E).

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Relative Prices with Trade

Using the supply and demand curves for both wheat and cloth (shown
below), we can see how the equilibrium-relative commodity price with
specialisation and trade is determined.

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Relative Prices with Trade

In the left panel, 𝑺𝑾(𝑼𝑺+𝑼𝑲) is the combined supply curve of wheat of the US
and the UK if both countries used all of their resources to produce only
wheat.

 Distance 0B = 180W represents the maximum quantity of wheat that

the US could produce with complete specialisation in wheat
production at the constant opportunity cost of Pw/Pc = 2/3.

 Distance BB* = 60W represents the maximum quantity of wheat that

the UK could produce with complete specialisation in wheat
production at the constant opportunity cost of Pw/Pc = 2.

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Relative Prices with Trade

 Thus, 240W is the maximum combined total quantity of wheat that

the US and the UK could produce if both nations used all of their
resources.

 Suppose that with trade (70W for 70C), the combined demand curve
for wheat of the US and the UK is 𝑫𝑾𝑼
( 𝑺+𝑼𝑲) , as shown in the left

panel. 𝑫𝑾 (𝑼𝑺 + 𝑼𝑲 )
intersects 𝑺𝑾(𝑼𝑺𝑼
+𝑲) at point E, determining the

equilibrium quantity of 180W and the equilibrium relative price of

Pw/Pc = 1 with trade.

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Relative Prices with Trade

We can do the same for cloth. In the right panel of the previous figure,

𝑺𝑪(𝑼+.𝑺𝑼..is
) the combined supply curve of cloth of the UK and the US if both
𝑲

countries used all of their resources to produce only cloth.

 The UK can produce a maximum of 120C = 0B’ at the constant

Pc/Pw= 1/2 and the US can produce a maximum of another 120C =
B’B’’ at the constant Pc/Pw = 3/2.

 Suppose that with trade (70W for 70C), the combined demand for

cloth of the UK and the US is 𝑫𝑪𝑼

( 𝑺.+𝑼𝑲) , as shown in the right panel of the

figure.

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Relative Prices with Trade

 𝑫𝑪(𝑼𝑺𝑼
+𝑲) intersects with at point E, determining
𝑺𝑪(𝑼𝑺+𝑼𝑲)
the
equilibrium quantity of 120C and the equilibrium-relative price of
Pc/Pw =1.

 Finally, note that with complete specialisation in both countries, the

equilibrium-relative commodity price of each commodity is between
the relative commodity price in each nation before trade.

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